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Optimal fiscal substitutes for the exchange rate in monetary unions

Christoph Kaufmann

Journal of Economic Dynamics and Control, 2019, vol. 103, issue C, 43-62

Abstract: This paper studies optimal monetary and fiscal policy in a New Keynesian 2-country open economy framework, which is used to assess how far fiscal policy can substitute for the role of nominal exchange rates within a monetary union. Giving up exchange rate flexibility leads to welfare costs that depend significantly on whether the law of one price holds internationally or whether firms can engage in pricing-to-market. Calibrated to the euro area, the welfare costs can be reduced by 86% in the former and by 69% in the latter case by using only one tax instrument per country. Fiscal devaluations can be observed as an optimal policy in a monetary union: if a nominal devaluation of the domestic currency were optimal under flexible exchange rates, optimal fiscal policy in a monetary union is an increase of the domestic relative to the foreign value added tax.

Keywords: Monetary union; Optimal monetary and fiscal policy; Exchange rate (search for similar items in EconPapers)
JEL-codes: F41 F45 E63 (search for similar items in EconPapers)
Date: 2019
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Related works:
Working Paper: Optimal Fiscal Substitutes for the Exchange Rate in a Monetary Union (2016) Downloads
Working Paper: Optimal fiscal substitutes for the exchange rate in a monetary union (2016) Downloads
Working Paper: Optimal Fiscal Substitutes For The Exchange Rate In A Monetary Union (2016) Downloads
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